I’ve had several people ask me to explain to them exactly what happened to cause the current recession and the near collapse of Wall Street last September 2008. The explanation is actually pretty simple:
- Too much consumer DEBT – rampant “consumerism” financed with DEBT.
- A massive trade deficit (more imports than exports) every year wherein the U.S. economy consumes far more than it produces. If we were purchasing or investing in industrial capacity which could be used to produce more exportable products that would be OK, but instead we’re purchasing consumption products that don’t add anything to our investment base or our production capability. Instead of buying factories and industrial capacity (investing) we’re buying consumption goods (TV sets and autos) This would be bad enough, but to make things even worse we’re purchasing these consumer products with massive amounts of DEBT!
- Too much government spending, financed by DEBT – the inability of our spineless political leaders to say “No” to government bailouts and programs to “help” every Tom, Dick and Harry.
- Financial institutions using too much DEBT (leverage) and not enough equity capital in their internal financial structures.
The reader will notice that too much DEBT and the trade deficit are the primary underlying causes of the problem, but the straw that almost broke the camels back in September 2008 is the sub-prime mortgage meltdown.
In the olden days when people bought a home they went to a Bank or a mortgage lender and, assuming they had a good credit history, they could get a home loan for 80 – 90% of the purchase price. The Borrower would have to:
- Have a good credit history;
- show adequate income to support the monthly mortgage payment;
- put a 10% to 20% down payment into the purchase of the house
A bank or mortgage company would then sell these mortgage instruments to the huge Wall Street investment banks (only 2 of the original 5 still exist) or to the two Government Sponsored Enterprises (GSE’s) with funny acronyms like, “Freddie Mac” and Fannie Mae” [“Fannie Mae” actually is the acronym for Federal National Mortgage Association.]. Let’s call these entities that purchase mortgages “Securitizers”. These mortgages (debt that is collateralized by a lien or security interest in a residential home) were accumulated and packaged into batches of mortgages and then “securitized” into multi-million dollar securities collateralized by the underlying mortgages and the homes these represented. For example, “Fannie Mae” or “Freddie Mac” would batch together the mortgages from thousands of different Borrowers into a financial instrument called an MBS or “Mortgage Backed Security”, which is nothing more than a piece of paper that says, in simplified terms, “I OWE YOU Twenty Million Dollars at 6% Interest and I will pay this back in monthly payments”. This IOU is backed or collateralized by the underlying home mortgages that pay back monthly payments. Basically, they are bonds collateralized by home mortgages, which are collateralized by homes. The “Securitizers” would then sell these MBS’s to the Asians, Russians, Middle East oil shieks, etc.
The home owner would then mail in his monthly payments to the “Securitizer” who would then batch all the monthly payments from all of the other home owners and mail the monies to the purchaser of the MBS — a Middle Eastern Sovereign Wealth Fund, a Saudi Arabian oil sheik, or the Chinese central bank, etc.,etc.
Everything worked just fine . . . for awhile. The mortgage originator, the Bank or mortgage company would make a home loan, then sell the mortgage loan to a “Securitizer” for cash. Once the Bank sold the mortgage and received its cash back it could then go out and make NEW mortgages with the cash it obtained from selling their earlier mortgages. This “system” helped the mortgage industry by providing a ready source of cash to make new mortgages. So there was always plenty of money to finance a thriving housing industry. In fact, there was so much money chasing the available real estate that it created a “bubble” in housing and real estate prices. The main way this happened was that it provided lots of cash to finance mortgages, which kept the interest rates down on the mortgages. Remember in the old days, the Banks could not sell the mortgages that they had originated so they would be forced to just sit on them and wait for them to pay off. The Banks would eventually run out of cash and the resulting liquidity shortfall would cause interest rates to rise which would choke off the demand for mortgage money. This would, in turn, choke off residential construction, which would create less need for carpenters, plumbers, carpet manufacturing, etc., etc. Wages would drop, economic activity would drop. If you can’t afford a mortgage payment because the interest rate is too high because there is a limited supply of lendable mortgage money there will be less demand for new homes. In other words the supply of mortgage money would have been limited which would result in the price of that limited quantity of money to rise. The “price” of money is the interest rate. High interest rates would have choked off the blossoming “bubble” in real estate prices — in hind sight that would have been a good thing.
So, in order to get around the problem of the Banks running out of money after making a few mortgage loans, the securitizing process was invented. This way the Banks can sell their mortgages, get their money back, make new loans, sell the mortgages, get their money back, make new loans, sell the mortgages, get their money back, on and on and on and on. The Banks charge enough fees in making a loan that it’s easy to see that if you can make 100 loans instead of just 50 loans, it will be way more profitable.
The Asians and the Middle East oil sheiks were earning trillions of dollars by selling us manufactured goods (Asia, Japan, etc.) or oil (Middle East). These recipients of our trillions of dollars did not want to stuff these dollars into their mattresses for safe keeping. Instead they wanted to invest these monies in safe, interest bearing securities. So, starting about 5 years ago the geniuses (I’m being facetious) on Wall Street noticed this huge supply of dollars that were being accumulated by our trading partners. The foreigners were purchasing all the MBS’s we could sell them and were hungry for more. They had more money than we had MBS’s. So the Wall Street geniuses went to the mortgage industry and said “hey why don’t you guys start making more home loans”. Well the only way you can make more home loans is to lower your credit standards. Remember that for every 10 people that want a home financed by a home loan, only about 6 in 10 people can qualify (have good credit scores, good cash down payments, good paying jobs, etc.) The remaining 4 out of 10 people get turned down and can’t buy a home. Imagine how much more money the banks could make if they made loans to the 4 out of 10 people that DON’T qualify. The “Securitizers” told the banks and mortgage companies “hey don’t worry about the quality of the loans you make, we’ll sell the loans to the Asians and the oil sheiks and they’ll get stuck with the crappy loans”. The banks and mortgage companies did not mind making crappy loans because they were going to sell the loans and by the time the loans went bad the Banks would have sold them to the “Securitizer” who would have then sold them to the Asians and Arabs.
This all worked great . . . for awhile! Matter of fact it worked so great that the Wall Street geniuses began to buy hundreds of billions of dollars worth of these MBS’s and put them into their own portfolios.
So what’s the fuss all about?
- Ok, you had a trillion dollars of loans made to people who didn’t qualify for an old fashioned mortgage loan – they had a bad credit history, low income, no down payment, etc.
- You loaned these people virtually 100% of the money to purchase a house at the peak in the prices of the real estate “bubble”.
This would have caused some pretty bad problems all by itself, but what caused the implosion is the way the Wall Street Banks arranged and structured their own internal financing. Here’s where the problem caused the implosion:
A Wall Street Bank would purchase, let’s say, $100 Billion of MBS’s. They got the $100 Billion from the following sources: $97 Billion of borrowed money (debt) and $3 Billion of actual cash equity. This is called using “leverage” because they took only $3 Billion of their own money and purchased $100 Billion of assets. They did this by using $97 Billion of “leverage” or debt. If the $100 Billion in assets goes up 3% in value ($3 Billion) they would make a 100% return on their money ($3 Billion of profit ÷ $3 Billion of cash equity = 100% profit on your investment). You can see that this use of “leverage” can give you a great return if things go good, but it can kill you if things go bad. A 3% loss ($3 Billion) would have completely wiped out the bank’s equity. So, because of this tremendous use of “leverage” or debt, these Wall Street geniuses could either get rich or go broke. Using this kind of “leverage” a Wall Street Bank can take a 3% profit on their portfolio of MBS’s and turn it into a 100% gain on their $3 Billion dollar cash investment. Likewise, a 3% loss on their portfolio could result in a 100% loss of their cash equity. The use of debt (leverage) was even worse with the Government Sponsored Enterprises (GSE). They used 100 to 1 leverage ratios: $101 in mortgage backed securities, financed by $100 of bonds and $1 of equity. In this situation, a 1% loss in the value of a MBS would completely wipe out the equity of the GSE. After that all the losses are born by the American taxpayer. Not surprisingly this structure was concocted and sanctioned by the trial lawyer clowns we’ve elected to “serve” us in Washington.
Now you throw into this risky and volatile situation a recession caused by a consumer re-trenchment caused by an inability to spend anymore because of an inability to take on anymore debt. The credit card, so to speak, got maxxed out!! Remember the savings rate in America dropped below zero percent – we were consuming everything we earned and then some! Remember the parable of the ant and the grasshopper? The American consumer is the grasshopper on steroids! Now comes the mortgage defaults and the collapse in house values. In the above example a small 3% drop in the value of the MBS’s would wipe out the Wall Street Banks. In the real world, mortgage defaults and falling real estate values caused 20%, 30%, 40% losses. So, not only do the Wall Street Banks begin to fail because the debts they incurred to buy the MBS’s are going into default, their lenders are losing money left and right. As these lenders lose money left and right, the value of their assets are going down to the point that their liabilities exceed their assets — they are now INSOLVENT too. It’s a never ending cycle of declining asset values, using too much debt, resulting in an ever widening circle of INSOLVENCY, almost dominoe like when the trouble hits the fan.
Now, it’s important to understand that the Wall Street Banks are not really “banks”. They are not chartered and registered and controlled like a regular bank is. They were able to get away with a 30 to 1 leverage ratio (assets of $31, debt of $30, equity of $1), unlike an FDIC insured commercial bank. Commercial Banks, like the one in your neighborhood, are only allowed to use a 10 to 1 leverage ratio, roughly speaking. As long as a Bank’s assets don’t decline in value by more than 10%, only the stockholders will get wiped out, the lenders (depositors) will be fine. But the current losses are so massive that even regular banks are seizing up. A bank can only lend money to people based on that 10 : 1 leverage ratio. If a Bank loses 10% of the value of its assets, which effectively wipes out the shareholder equity, then it can no longer lend money to its customers until it re-capitalizes itself with more money.
Right now lots of banks have varying quantities of these MBS’s being held as an asset of the bank. But because of the massive amounts of borrower defaults and declining real estate values nobody wants to purchase these securities from the Banks, so their market value has nose-dived. No one wants this “toxic waste” and banks cannot sell it. If you can’t sell it, then it has no value. As the value of these investments falls, according to “mark to market” accounting rules, it wipes out the bank’s equity capital. Remember for every $1 of equity capital a bank has, it can lend $10, but if your capital is reduced you have to reduce your lending. If you have to reduce your lending then the business down the street who is trying to meet its 1st of the month and 15th of the month payroll won’t get the money and no one gets paid on pay day. Likewise, car loans don’t get made. Credit cards don’t get issued. Debt for every purpose gets difficult to obtain, or it gets very expensive. As this situation began roiling through our financial system and our economy, businesses found themselves unable to obtain financing. Unable to obtain financing they began laying off employees. Combining the above factor with the systemic problem of too many consumers with too much debt and you get the following:
- a decline in retail purchases, so retail outlets have less business therefore they need fewer employees;
- a slow down in home sales, so realtors, appraisers, home inspectors, etc. have less business therefore they need fewer employees;
- a slow down in home sales results in a slow down in durable goods purchases (washing machines, appliances, A/C units, etc.) resulting in the need for fewer employees;
- a slow down in home construction resulting in massive layoffs in the construction trades;
- a slow down in mall, strip center, and commercial construction resulting in additional massive layoffs in the construction trades;
- a slow down in heavy equipment purchases resulting in the need for fewer employees;
- a slow down in manufacturing capacity resulting in the need for fewer employees
The slowing of the economy results in more job layoffs, resulting in more slow downs in economic activity, resulting in more job layoffs, resulting in even less economic activity — a vicious cycle! This is where we are at the current moment.
-
- Add precious metals to your portfolio purchase from GoldBank, LLC.
-
- Buy Silver and Gold with GoldBank, LLC.
